Strengths and risks in the latest buyout fund rule amendments

The China Securities Regulatory Commission amended the Measures for the Administration of Material Asset Restructuring of Listed Companies (Restructuring Measures) and the Measures for the Administration of the Acquisition of Listed Companies (Acquisition Measures) in April.

According to the measures, administrative approvals for acquisitions/restructurings of A-share listed companies not involving backdoor listings or the offering of shares to purchase assets will be abolished. The measures also stipulate that “lawfully established investment institutions, such as buyout funds, equity investment funds, venture capital funds, industry investment funds, etc., are encouraged to participate in the acquisitions and restructurings of listed companies”.

This has greatly reduced the burden of acquisition/restructuring approvals and is conducive to further promoting restructurings of listed companies by way of buyout funds. According to statistics compiled by ChinaVenture, as of December 2014, more than 80 listed companies were involved in the establishment of buyout funds, totalling in excess of RMB 70 billion (USD$11.3 billion).

The amendments made a number of changes. They abolished approval for material purchases, sales and exchanges of assets that do not constitute backdoor listings, along with prior approval for takeovers by offer and approval for two types of exemptions from takeover offers. They improved the market pricing mechanism for offerings of shares to purchase assets. They also better defined backdoor listings, clarifying that requirements equivalent to those for IPO reviews will be implemented for backdoor listings and expressly specified that backdoor listings are not permitted for companies listed on second boards.

In the amendments to the measures, they also increased the payment instruments available for acquisitions/restructurings. The threshold limitations on offerings of shares to unconnected third parties for asset purchases and the requirements of mandatory provisions for profit forecast compensation were abolished. They strengthened during-the-fact and after-the-fact oversight and procured the due performance of their duties by intermediary firms. Finally, they laid out complementary arrangements for the protection of investors’ rights and interests.

Operational model

The chief participation model for a listed company buyout fund is via private equity (PE), although in certain cases securities brokerages or banks have also been used. A listed company and PE collaborating to establish a buyout fund to carry out project investment is a win-win situation for both parties. In a buyout fund, the listed company changes from a limited partner simply making capital contributions into a quasi general partner with the right to speak in investment decision-making. The listed company can accordingly call upon the PE professional investment team and financing channels to leverage relatively large acquisition resources with relatively little capital, which it can then invest in upstream/downstream enterprises in its own industry or production chain.

It can operate the subject of the acquisition for a certain period of time under the control of the buyout fund and guard against negative impact on its short-term performance due to post-acquisition uncertainties. As for PE, the A-share bottleneck has made divestment by the IPO model much more difficult. If a listed company participates in the establishment of projects in which the buyout fund invests, they will generally be bought back preferentially by the listed company, giving the PE firm a shot in the arm.

New Energy Industry Buyout Fund established by Guangdong Hec Technology Holding and Jiupai Capital is an example of a listed company directly collaborating with PE to establish a buyout fund. Zhongheng Group establishing a healthcare buyout fund is an instance of a listed company collaborating with a connected party and then joining hands with PE to establish a buyout fund.

The cultural investment fund established by Contemporary Eastern and a subsidiary of HuaAn Funds is a case of a listed company collaborating with a PE subsidiary in the creating a buyout fund. Finally, the establishment of a pharmaceutical investment fund by a subsidiary of Zhongyuan Union and Yinhong Fund is an example of a listed company’s subsidiary establishing a PE buyout fund.

Reading the risks

As per the Enterprise Accounting Standards, if a listed company assumes control over the production and operational decision-making of a target company at the time that it takes control over that target company, a change in the control of the target company has occurred, and this should be included in the consolidated statements of the listed company. The
determination of control should comply with the principle of substance over form and is not solely dependent on the shareholding percentage.

As above, the business chain achieved via a PE buyout fund involves two acquisitions. The listed company should become involved in the operation and management of the target company after the first acquisition. Accordingly, once the listed company can effectively control the decision-making of the buyout fund, it achieves control over the target company and is required to include the target company in its consolidated statements before the second acquisition when it assumes control over the day-to-day operations of the target company after the first acquisition.

This runs counter to the original reason for establishing a PE buyout fund, defeating the listed company’s intention of buffering its investment.

If a connected party of the actual controller of the listed company makes a capital contribution to the buyout fund, that will give rise to a conflict of interest between the listed company and its actual controller. As it is in the interest of the actual controller to procure the second acquisition by the listed company to realize its returns, there is a strong likelihood that the drama often seen in the A-share market of a major shareholder hollowing out a listed company by way of a connected transaction will play out.

When a PE buyout fund is promoted through the listed company, cross-shareholdings may become an issue. With the listed company contributing capital to the buyout fund and the buyout fund holding an equity interest in the target company, if the listed company ultimately offers shares to the buyout fund to purchase the equity it holds in the target company, it will create a cross-shareholding between the listed company and buyout fund. While there are no regulations expressly prohibiting cross-shareholdings by listed companies, from the perspective of review policy, cross-shareholdings have always been something that the regulators have required be avoided nonetheless.

Sun Jian is a senior partner and Wang Junlu is a lawyer at Zhong Yin Law Firm